Small Caps Become A Victim Of Momentum

Veteran stock picker James Oberweis has seen the best of times and the worst of times in the market for small-company stocks. These days, he's seeing both at the same time.

"One of the frustrating things when we were talking to investors last fall was to hear, `I can't buy (small-cap funds) because everybody's buying big caps. I'll buy them when they turn higher.' "

But after a dramatic year-end rally in small-cap stocks that began Oct. 8, many investors are telling Oberweis, "Now, it's too late."

Nowhere is investor sentiment more fickle than in the sector of the market known as small-cap stocks, which are said to include stocks of less than $1.5 billion in market capitalization--the number of shares times their price.

Analysts concur that never before in stock market history has the value of small-company stocks--measured by share price versus earnings per share or a host of other relative-performance measures--been more attractive when compared to large-company stocks.

Yet it's hard for managers of small-cap mutual funds to keep redemptions from creating a vicious cycle of losses.

"This is a momentum-driven market," said John Raitt, research director at Chicago-based Harris Associates.

Momentum works both ways, of course. Despite the rally in the last three months of the year, small-cap stock funds as a group posted a slight loss in 1998, while large-cap funds gained more than 20 percent.

When the Federal Reserve cut interest rates three times last fall, "it was like firing a pistol" for the stock market, he said. But it turned out to be a sprint, not a marathon for the small-company sector. The group ran out of gas in January, when speculation-oriented investors, who traditionally favor the sector, began chasing Internet stocks and big-name computer-technology stocks.

The Russell 2000 index, which is the benchmark for many small-cap fund managers, gained just 1.3 percent in January, after a 36 percent jump from Oct. 8 to Dec. 31.

But that spurt was not enough to turn the tide of investor sentiment in small caps' favor.

"There's been no need for institutions to own small stocks recently," said William Lowery, executive vice president of Performance Analytics, a Chicago-based firm that advises pension funds, endowments and other institutional portfolios. Until last year, big stocks "had better earnings than small stocks."

Although the earnings growth trend seems to have shifted in favor of small companies, the momentum behind the big-name growth stocks and Internet stocks has overwhelmed the small-stock story.

The Oberweis Emerging Growth Fund and Micro Cap Fund own stocks that have posted 90 percent gains in earnings and sales in the last 12 months and are expected to do the same this year. Oberweis says he won't buy a stock that hasn't demonstrated sustainable growth rates of at least 30 percent.

On the other hand, analysts expect the companies in the Standard & Poor's 500 index to increase earnings by only 5 percent to 7 percent in 1999. And some of the most popular Internet stocks have no earnings at all.

Last fall's rally in small-cap stocks appeared to recognize the superior earnings growth of the group, but the stock market has become captivated by stock price growth, not earnings growth, Oberweis said.

Ironically, many stagnating small-cap stocks are punished in today's market by reporting improved earnings. Higher earnings per share push their price-earnings ratio lower and make them even less attractive to investors chasing high P/E growth stocks.

"We are blocked out because we like earnings and P/Es that are not out of sight," Oberweis said.

Lowery said institutional investors have not abandoned small-company stocks as a category of the stock market they wish to own. Eventually, he said, "Stock prices follow earnings."

Right now, small-stock investors have no idea when that will happen.

"We have a lot of companies where the profits keep improving and the stocks keep slumping,' said Raitt, who pointed to hotel developer Prime Hospitality as an example of the lamentable trend. The stock slumped from a high of $21.25 last year to a low of $4 and closed Thursday at $9.94.

"It's the same case with all undervalued stocks," he said. "You can't identify what the catalyst will be (for a sustained rally), but the biggest factor in your favor is time."

Share repurchases by small companies and merger and acquisition activity are two catalysts that Raitt said he believes could rekindle last fall's small-stock rally.